Endurance test for Japan’s economy

Tom Stevenson, Fidelity, 14 August 2013

*This week Tom's column was written by Anthony O’Connor*

The next few months will be an especially testing time for prime minister Shinzo Abe’s government and its high-profile package of economic reforms known as Abenomics. The stakes are high: a wrong policy move has the potential to bring the complex house of cards crashing down, sending the country back into recession.

With this in mind, there’s a spotlight on whether prime minister Abe will forge ahead with his contentious policy of raising value-added tax (VAT) from 5% to 8% at the start of next April’s fiscal year. The plan, which was approved by parliament last year, has the backing of Japan’s central bank governor Haruhiko Kuroda who believes the government’s pro-growth policies will counteract any negative effects of the tax hike.

Japan desperately needs to start chipping away at its public debt that stands at 250% of national income, built up after years of persistent deflation and relentless government borrowing. So, asking consumers to pay 8% VAT, stepping up to 10% in 2015, pales in comparison to the 18% average in OECD countries. But the jury is split about the timing of this policy.

If prime minister Abe goes ahead with this tax and Japanese consumers reject it by keeping their wallets shut, not only will this hamper any GDP increase but could even result in a return to deflation and recession if some analyst warnings are to be believed.

Somewhat concerning, earlier this week official data showed GDP growth slowed to an annualised 2.6% for the three months to the end of June. While this is twice the pace of growth Japan has recorded for much of the last decade, it was down from the previous quarter and a full percentage point down on the analyst consensus.

So far, Abenomics – still very much a work in progress – has succeeded in part by spurring economic growth through a combination of public works spending and aggressive monetary easing. In the quarter to June, private consumption increased by 3.1% and the value of exports rose in value by 12.5%, but business investment fell by an annualised 0.4%.

It’s no surprise then that the markets reacted positively to news this week of fresh government-level discussions about ways to cut corporate taxes to encourage more business investment. On the back of this, the Nikkei Stock Average increased by 2.5% by the close of trading on August 12, led by buying of blue-chip exporters.

The Abenomics monetary policy targets a doubling of the inflation rate to 2% – although a challenging target, so far this policy seems to have been quite successful in terms of weakening the yen which has clearly boosted export demand. In turn this has led to increasing production and corporate earnings, boosting household incomes and stimulating domestic consumption.

If Abenomics gives corporate Japan tax breaks to reinvigorate the economy by investing in businesses then it would be a logical deduction that Japanese consumers are given every encouragement to spend. It could be too early for Abenomics’ policymakers to assume that improved corporate earnings have already translated into higher salaries and bonuses for Japanese workers.

As prime minister Abe has the authority to postpone the increase in the consumption tax, it’s possible its introduction could be linked to a GDP growth rate trigger, say of 3%, for example. In any case, we should know by October if the tax increase is likely to go ahead next year or modified, perhaps with a smaller increase, after the revised GDP figures for the April-June quarter are available.

Just nine months into this government, Abenomics promises a lot with its monetary and fiscal policies. But the third arrow of market reform looks set to be the most challenging as prime minister Abe attempts to restructure the labour force, break down historically restrictive practices, reopen Japan’s nuclear industry, promote Japan’s interest in trans-Pacific trade relations and re-establish the country’s geopolitical credentials.

Note the value of an investment and the income from it can go down as well as up, so you may get less than you invested and tax rules and allowances can change. The ideas and conclusions in this column are the author's own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. Past performance is not a guide to what may happen in the future and the figures and returns in this article are purely to illustrate the author's points.

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